3

Forecasting

McGraw-Hill/Irwin

Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning Objectives
List the elements of a good forecast. Outline the steps in the forecasting process. Describe at least three qualitative forecasting techniques and the advantages and disadvantages of each. Compare and contrast qualitative and quantitative approaches to forecasting.

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Learning Objectives
Briefly describe averaging techniques, trend and seasonal techniques, and regression analysis, and solve typical problems. Describe two measures of forecast accuracy. Describe two ways of evaluating and controlling forecasts. Identify the major factors to consider when choosing a forecasting technique.
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How the car buyer think ?

He want it as soon as possible He do not have to wait any time for delivery If the dealer is not ready to deliver at once the buyer look elsewhere

Hence
It is important for a dealer to anticipate buyer wants and to have those models, with the necessary options, in stock
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How the car buyer think ?

The dealer who can correctly forecast buyer wants, and who have those cars available, is going to be much more successful than a competitor who guesses instead of forecasting He usually
Guesses wrong !!!!!! Gets stuck with cars customers dont want !!!!!!!

So, how does the dealer know how many cars of each type to stock ? The answer is : The dealer doesnt know for sure, but by analyzing previous buying patterns, and perhaps making allowances for current conditions, the dealer can come up with a reasonable approximation of what buyers will want

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Planning and Uncertainties

The manager is a planner Uncertainty make planning difficult Forecasting reduce uncertainty
Forecasting enable manager to develop more meaningful plans

so

What is forecasting ?
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What is forecasting ?
FORECASTING IS:
A statement about the future value of a variable of interest such as demand. Forecasting is used to make informed decisions. Long-range ( several years, country, organization, town, city . ) Short-range ( several weeks, days, operation People make and use forecasts all the time both in their jobs and in everyday life
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Forecasts
Forecasts affect decisions and activities throughout an organization
Accounting, finance Human resources Marketing MIS Operations Product / service design

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Uses of Forecasts
1. Help managers plan the system ( long term )
Types of products to offer Facilities and equipment to have, to locate

2. Help managers plan the use of the system ( short term )

Planning inventory Work force level Planning purchasing and production Budgeting and scheduling
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Uses of Forecasts
Accounting Finance Cost/profit estimates Cash flow and funding

Human Resources Marketing

MIS Operations Product/service design

Hiring/recruiting/training Pricing, promotion, strategy

IT/IS systems, services Schedules, MRP, workloads New products and services

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Features of Forecasts
Assumes causal system past ==> future
Forecasts rarely perfect because of randomness Forecasts more accurate for groups vs. individuals
I see that you will get an A this semester.

Forecast accuracy decreases as time horizon increases

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Elements of a Good Forecast

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Steps in the Forecasting Process

The forecast

Step 6 Monitor the forecast

Step 5 Make the forecast Step 4 Obtain, clean and analyze data Step 3 Select a forecasting technique
Step 2 Establish a time horizon Step 1 Determine purpose of forecast

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Approaches to forecasting
Qualitative:
Consists of subjective inputs Includes soft information (human factors, personal opinion)

Quantitative:
Consists of objective inputs
Involve hard data (projection of historical data, analyzing objectives)
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Types of forecasting techniques

Judgmental - uses subjective inputs obtained from various resources Time series - uses historical data assuming the future will be like the past Associative models - uses explanatory variables to predict the future

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Judgmental Forecasts
Executive opinions
Sales force opinions Consumer surveys Outside opinion

Delphi method
Opinions of managers and staff
Achieves a consensus forecast

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Executive opinions
estimation probability Est. * prob.

Production manager marketing manager Financial manager

125

40%

50

160

35%

56

100

25%

25

General manager

131

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Delphi method
Session 1 Session 2 Session 3 Session 4

Expert 1

4.5

Expert 2

3.5

3.5

3.5

Expert 3

4.5

4.5

Expert 4

4.5

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Time Series Forecasts

Plotting the past data and visually examining the appeared pattern:
Trend - long-term movement in data Seasonality - short-term regular variations in data Cycle wavelike variations of more than one years duration Irregular variations - caused by unusual circumstances Random variations - caused by chance
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Forecast Variations
Figure 3.1
Irregular variation

Trend

Cycles
90 89 88 Seasonal variations

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Naive Forecasts
Uh, give me a minute.... We sold 250 wheels last week.... Now, next week we should sell....
The forecast for any period equals the previous periods actual value.

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Nave Forecasts
Simple to use Virtually no cost Quick and easy to prepare Data analysis is nonexistent Easily understandable Cannot provide high accuracy Can be a standard for accuracy

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Uses for Nave Forecasts

Stable time series data
F(t) = A(t-1)

Seasonal variations
F(t) = A(t-n)

Data with trends

F(t) = A(t-1) + (A(t-1) A(t-2))

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Techniques for Averaging

Moving average Weighted moving average Exponential smoothing

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Moving Averages
Moving average A technique that averages a number of recent actual values, updated as new values become available.

Ft = MAn=

At-n + At-2 + At-1 n

Weighted moving average More recent values in a series are given more weight in computing the forecast.

Ft = WMAn=

wnAt-n + wn-1At-2 + w1At-1

n
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Simple Moving Average

Actual

MA5

47 45 43 41 39 37 35 1 2 3 4 5 6 7 8 9 10 11 12
MA3

Ft = MAn=

At-n + At-2 + At-1

n
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Exponential Smoothing

Ft = Ft-1 + (At-1 - Ft-1)

Premise--The most recent observations might have the highest predictive value.

Therefore, we should give more weight to the more recent time periods when forecasting.

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Exponential Smoothing

Ft = Ft-1 + (At-1 - Ft-1)

Weighted averaging method based on previous forecast plus a percentage of the forecast error A-F is the error term, is the % feedback

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Example 3 - Exponential Smoothing

Period 1 2 3 4 5 6 7 8 9 10 11 12 Actual 42 40 43 40 41 39 46 44 45 38 40 Alpha = 0.1 Error 42 41.8 41.92 41.73 41.66 41.39 41.85 42.07 42.36 41.92 41.73 -2.00 1.20 -1.92 -0.73 -2.66 4.61 2.15 2.93 -4.36 -1.92 Alpha = 0.4 Error 42 41.2 41.92 41.15 41.09 40.25 42.55 43.13 43.88 41.53 40.92 -2 1.8 -1.92 -0.15 -2.09 5.75 1.45 1.87 -5.88 -1.53

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Picking a Smoothing Constant

Actual

50
Demand

.4

45 40 35 1 2 3 4 5 6 7 8

.1

9 10 11 12

Period

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Common Nonlinear Trends

Figure 3.5 Parabolic

Exponential

Growth

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Linear Trend Equation

Ft

Ft = a + bt
0 1 2 3 4 5 t

Ft = Forecast for period t t = Specified number of time periods a = Value of Ft at t = 0 b = Slope of the line

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Calculating a and b
n (ty) - t y b = 2 - ( t) 2 n t

y - b t a = n

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Linear Trend Equation Example

t Week 1 2 3 4 5 t2 1 4 9 16 25 y Sales 150 157 162 166 177 ty 150 314 486 664 885

t = 15 t2 = 55 2 ( t) = 225

y = 812 ty = 2499

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Linear Trend Calculation

b = 5 (2499) - 15(812) 5(55) - 225 = 12495 -12180 275 -225 = 6.3

812 - 6.3(15) a = = 143.5 5

y = 143.5 + 6.3t
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Techniques for Seasonality

Seasonal variations
Regularly repeating movements in series values that can be tied to recurring events.

Seasonal relative
Percentage of average or trend

Centered moving average

A moving average positioned at the center of the data that were used to compute it.

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Associative Forecasting
Predictor variables - used to predict values of variable interest Regression - technique for fitting a line to a set of points Least squares line - minimizes sum of squared deviations around the line

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Linear Model Seems Reasonable

X 7 2 6 4 14 15 16 12 14 20 15 7 Y 15 10 13 15 25 27 24 20 27 44 34 17

Computed relationship
50 40 30 20 10 0 0 5 10 15 20 25

A straight line is fitted to a set of sample points.

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Linear Regression Assumptions

Variations around the line are random Deviations around the line normally distributed Predictions are being made only within the range of observed values For best results:
Always plot the data to verify linearity Check for data being time-dependent Small correlation may imply that other variables are important
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Forecast Accuracy
Error - difference between actual value and predicted value

Mean Absolute Deviation (MAD)

Average absolute error

Mean Squared Error (MSE)

Average of squared error

Mean Absolute Percent Error (MAPE)

Average absolute percent error

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MAD, MSE, and MAPE

MAD = Actual forecast

n
MSE = ( Actual forecast)
2

n -1
( Actual forecas t n

MAPE =

/ Actual*100)

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MAD, MSE and MAPE

MAD
Easy to compute Weights errors linearly

MSE
Squares error More weight to large errors

MAPE
Puts errors in perspective

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Example 10
Period 1 2 3 4 5 6 7 8 Actual 217 213 216 210 213 219 216 212 Forecast 215 216 215 214 211 214 217 216 (A-F) 2 -3 1 -4 2 5 -1 -4 -2 |A-F| 2 3 1 4 2 5 1 4 22 (A-F)^2 4 9 1 16 4 25 1 16 76 (|A-F|/Actual)*100 0.92 1.41 0.46 1.90 0.94 2.28 0.46 1.89 10.26

MAD= MSE= MAPE=

2.75 10.86 1.28

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Controlling the Forecast

Control chart
A visual tool for monitoring forecast errors Used to detect non-randomness in errors

Forecasting errors are in control if

All errors are within the control limits No patterns, such as trends or cycles, are present

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Sources of Forecast errors

Model may be inadequate Irregular variations Incorrect use of forecasting technique

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Tracking Signal
Tracking signal
Ratio of cumulative error to MAD

(Actual-forecast) Tracking signal =

MAD
Bias Persistent tendency for forecasts to be Greater or less than actual values.

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Choosing a Forecasting Technique

No single technique works in every situation Two most important factors
Cost Accuracy

Other factors include the availability of:

Historical data Computers Time needed to gather and analyze the data Forecast horizon
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Operations Strategy
Forecasts are the basis for many decisions Work to improve short-term forecasts Accurate short-term forecasts improve
Profits Lower inventory levels Reduce inventory shortages Improve customer service levels Enhance forecasting credibility

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Supply Chain Forecasts

Sharing forecasts with supply can
Improve forecast quality in the supply chain Lower costs Shorter lead times

Gazing at the Crystal Ball (reading in text)

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Exponential Smoothing

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Linear Trend Equation

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Simple Linear Regression

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